Is the Umeme IPO a Bargain?

It’s been a long dry spell for Ugandan IPOs. The Uganda Securities Exchange hasn’t seen a new local listing since the National Insurance Company floated some shares back in March 2010 – more than two and a half years ago.

So, when the national electricity distribution company, Umeme, launched its IPO last week it created plenty of buzz in Kampala.

Should retail investors sign up for some shares? Or should they avoid them like a live wire?

Details of the Umeme IPO

Umeme operates Uganda’s electricity distribution system. It does not generate or transmit electricity, it is only responsible for power lines and equipment between the large transmission towers and the electricity consumer, very much like Kenya’s KPLC. Its 20-year contract to run the distribution system lasts until 2025.

The London-based private equity firm Actis presently owns 100% of Umeme. The IPO will result in Actis selling a 38% stake in the company for roughly $26 million. Umeme will use this sum to pay down long-term debt and position it to extend and improve the electricity grid.

The IPO shares carry a UGX275.00 ($0.11) price tag. Over half of the offer is available only to East Africans and 20% is specifically reserved for East African retail investors. Foreign investors have already snapped up the 46% allocation allotted to them.

The offer concludes on November 7 and the newly minted Umeme shares will begin trading on the Ugandan stock market on November 30, 2012.

So with that brief profile, let’s consider the bull and bear case.

Photo by Stefan Gara

The Cheers

Umeme’s a monopoly. It doesn’t need to worry about a competitor cutting a chunk out of its sales.

“There’s huge demand for electricity in Uganda,” says Davis. Only 4% of Ugandans have access to the grid, and with the discovery of oil, the country’s economic growth looks set to accelerate, further increasing the need for electricity.

Mark notes that Umeme passes all costs of energy production on to the consumer. So, if the cost of a kilowatt hour rises 20%, it doesn’t eat into the company’s margins. Umeme’s role is simply to collect bills and build out and improve the distribution infrastructure. Moreover, the construction of new power plants means the company has power available to deliver.

“With the money it will raise, Umeme has the opportunity to clean up its balance sheet and, in turn, reduce finance costs,” says Mark. This directly impacts the bottom line, freeing up resources to extend the grid to new customers and invest in efficiency improvements like prepaid meters.

Davis likes Umeme’s profitability compared to its Kenyan counterpart. “Umeme’s ROE stands at 21% while Kenya Power’s is only 10.6%,” he says.

Davis also lauded Umeme’s proposed dividend policy. Management intends to pay out 50% of earnings as dividends to shareholders.

The Jeers

Umeme is a regulated monopoly, and therefore it cannot set its own rates, explains Davis. It is at the mercy of populist politicians, who may be loath to approve a tariff increase during election season even if the company’s profitability requires it.

Mark cautions that Umeme will need to invest heavily in order to increase the amount of electricity it distributes. It already plans to sink $300 million into new meters. This will almost certainly require increasing the company’s debt burden. Increased interest charges will dampen earnings growth.

Davis notes that the company must clamp down on power theft and vandalism. “Umeme loses over 25% of its power to theft. Meanwhile, Kenya Power loses just 15-17%,” he says.

“What happens when Umeme’s concession with the government expires in 2025?” wonders Mark. If the company does not succeed in securing another 20-year contract as the sole electricity distributor, it will need to dissolve and return assets to shareholders. The prospect of this happening will likely burden the share price. The IPO may actually be Actis’ way of inoculating itself against such an event. If Ugandan investors own nearly a quarter of the company, the political pressure to award it a contract renewal will be significant.

Davis has some concerns about the size of Umeme’s debt load. “At listing, the debt to equity ratio stands at 70%,” he notes. “This bears watching because some of these loans are denominated in US Dollars, exposing the company to forex losses.”

The Verdict

After hearing Davis and Mark’s analysis and reading through the prospectus, I believe Umeme’s IPO price offers some value.

Given management’s proposed 50% payout ratio and its forecast EPS of UGX30, the IPO price offers a dividend yield of approximately 5.5%.

At listing, the company will trade at 2.2x book value with an ROE over 20%.

Considering all of the above, I arrive at a price target of UGX315 per share for Umeme. If it should reach that price over the next year, IPO investors would reap a 14.5% local currency capital gain. Add in the dividend yield of 5.5% and I see the possibility of a total local currency return of 20%.

What Do You Think?

Is the Umeme IPO worth a closer look? Tell us why or why not in the comments!

[Disclosure: Both Mika Davis and Mark Keith Muhumuza will be participating in the Umeme IPO. Ryan will not be participating.]

[Please note that this is not a de facto recommendation, but simply a beginning point for your own research. Let your own due diligence and critical thought be your guide before making any investment decision.]

Comments

The overriding factor is that it is a monopoly and demand for power will continue to grow make it very attractive. I still think the management’s pledge to give 50% of earning as dividend is too ambitious and not sustainable since expansion will be a critical part of the company in creating growth of its customer base and revenue.

I used a blended valuation model that assumed 22% earnings growth in the near-term and a 50% payout ratio with a required dividend yield of 4% and earnings yield of 10%. I plan to dig into an explanation of the model in future articles.

But if it’s a monopoly and actis is laying a chunk of it off right now? With the energy demand in Africa right now? Either actis need money or the UG government is being a pain in the ass. Nevertheless, I think it’s a good buy. It’s got a good vibe with the foreign interest on it. Not much, but enough for profit takers (like us) to make money on it. But your valuation models are questionable.